Credit Markets Still Careening Around the Bend

In my summer newsletter I used “ominous turn” to describe the direction of the credit markets.

Picture a vehicle careening around a hairpin turn on a steep mountain road, two wheels off the ground. Most Americans and Congress are in the trunk of this vehicle. Paulson and Bernanke are in the back seat, wrestling with the steering wheel that has come off in their hands, trying to get it back on the steering shaft. They have looked over the edge, nearly wet their pants, and are desperately trying to convince Congress to put up temporary guardrails for the financial system, lest Americans find their investment and employment vehicles plummeting from the highway of traditional business cycles into the steep ravine of economic depression.

THE GUARDRAILS ARE BEING CALLED a “taxpayer bailout.” It is a poor choice of words for the latest $700 billion dollar financial sector stabilization package. A bailout implies that someone is getting out of trouble at little cost to themselves for the mess they created.

What the Bill Is Not
So far, a “bailout” is not what the evidence suggests.
The rescue of Bear Stearns was proposed at $2/share by the government – a price 98% lower than what the stock had traded at the previous year. The deal later got done at $10/share after J.P. Morgan offered to pay more. Management and employees were nevertheless devastated by the losses in their company stock, which had traded as high as $172/share in January 2007 and $93/share in February 2008. This was no bailout for them.

Lehman Brothers’ bankruptcy (no rescue) resulted, for example, in CEO Richard Fuld, Jr., selling his Lehman stock, once worth $740 million, at a value of less than $1 million. This doesn’t sound like a bailout to me.

Then there were the stockholder losses at Fannie and Freddie … including a $430 million dollar loss in Freddie by legendary value investor Bill Miller of Legg Mason Value Fund, who failed to appreciate that the near monopoly position that these companies would enjoy lending to homeowners would be trumped by these companies’ over-borrowing and loan losses. Shareholders were wiped out. (Expect Fannie and Freddie to be sold back to the public at some point.)

The Congressional Budget Office summed it up nicely:
The cost of TARP “depends on three factors: (a) the degree to which the transactions result in a gain or loss to the government; (b) the administrative costs of running the program; and (c) any interactive effects with other government programs.” The Office concluded that, “Although the lack of specificity in the bill means that CBO cannot currently quantify its net budgetary impact, and although there is some possibility that the government could realize a net gain on the transactions authorized under the bill, it seems more likely that enacting the bill would result in an increase in the federal deficit. In other words, the net budgetary cost (including administrative costs) is very likely to be substantially smaller than $700 billion, but it seems likely to be greater than zero” [italics mine].

What the Bill Is
The actual name of the “bailout plan” is the Troubled Asset Relief Plan, or TARP.
Background: Financial institutions have too many loans going bad. The result has been huge losses and business failures. Financial institutions are now afraid to lend to each other and don’t trust each others’ guarantees, which are supposed to assure the lender that the money will be paid back. The lack of trust is due to the fact that each time the financial institutions thought they had written down problem loans, those loans turned out to be worse than expected, causing even more write-downs.

TARP is a government program designed to buy these troubled loans from financial institutions and therefore (it was hoped) eliminate the fear that these companies have of lending to one another. The idea was that with this fear reduced or eliminated, financial institutions should start trusting and lending to each other again, restoring the flow of credit and reducing interest rates.

The cost to tax payers is not known, but evidence and reason suggested it should be substantially less than the headline $700 billion TARP cost.

In previous real estate–driven banking crises, both in the United States and abroad, interest rates fell significantly, economic growth slowed, and credit demands slackened. While markets are aware of the potential increase in bond issuance in today’s circumstances, U.S. Treasury bond rates have declined as money flowed out of foreign countries to the safety of U.S. government bonds. Future increases in Treasury debt issuance should be offset by lower consumer and business demand for credit as the economy slows and consumers focus on savings to rebuild their tattered finances. A difficult, slow growth environment will likely persist for at least five years.

On November 12th, Treasury Secretary Henry Paulson announced that TARP would shift its focus from buying bank loans to jump starting consumer credit creation. Consumer purchases make up 70% of economic growth, and credit plays a major role in consumer purchases. Unfreezing consumer credit is needed to mitigate the rapid deceleration in economic growth. And herein lies the conundrum: for consumers to rebuild their finances, they must forego the use of credit and start saving.

What the government should be doing is encouraging those with stable incomes, adequate savings, and little or no debt (the ever-thrifty who have won the financial independence game – i.e., most of my clients) to resist the temptation to jump on the “We gotta cut back too!” bandwagon. Do not be afraid or embarrassed to spend normally – you are helping others to keep their jobs.